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Is Your Internet Business
Subject to Sales Tax?

Electronic Software Distribution:

The Internet is an exploding business opportunity for many of us. In 1997 there was $10 billion in business on the Internet in 2002 it is estimated to be 220 billion! There are many unanswered questions on how this business will be taxed at the state level.

Recently, the President placed a three-year moratorium on the states from adding any additional taxes to the Internet then those that already exist. Many people think this means there is a free-for-all in that you do not have to pay state taxation on Internet business other than in the state where your business operation is located. Worse yet, many people think they can live anywhere and run their money through a state like Nevada with no state personal or corporate income tax and pay no state taxes in the state from which they do their work. This is simply not true.

In fact, most seem to forget that the Internet is very similar to the mail order business. Meaning, if you sell a tangible product by sending information around the country, and everyone has to send a check to your home office and the product is shipped out of your home office, then you do not have to register as a foreign corporation in those other states (this falls under Public Law 86-272). If you actually travel to a state with your products and collect a check in another state, as opposed to the check coming to the home office and having the product shipped from there, you then are beyond the protection of Public Law 86-272 and may have to register as a foreign corporation in the other state. If you sell computers to someone in your state you would charge him/her sales tax. If someone out of state ordered a computer from you and you shipped it to him/her, that would not be subject to sales tax. This all changes when an intangible product like services is involved. It is much easier with services to be considered doing business in other states than with tangible products. You must then examine the frequency of doing business in another state with intangibles to determine if your corporation needs to register in that state.

You can guarantee that in-so-far as Internet sales are involved, the states are not going to just let all this additional revenue disappear from their state taxation jurisdiction. Just consider the case of Geoffrey, a trademark name for Toys "R" Us. The company that owns the trademark Geoffrey is located in Delaware. The state of South Carolina claimed that income was flowing out of South Carolina to Delaware for trademark fees (an intangible); and that they wanted to collect a state income tax on this revenue. Historically, just having a trademark in a state didn’t create sufficient nexus for tax to be paid in that state. This case changed that. South Carolina was able to collect state taxes on the trademark of Geoffrey in its state. Do you think the states are going to roll over and play dead when they know you are in the adjoining state doing 35 million dollars a year over the Internet and you are not paying a dime of state taxes in their state? They will do everything in their power to try and claim they have a right to tax part of that revenue! You may find a lot of state audits of Internet business in years to come. This area is uncertain. Keep in mind all 50 states already have rules in place to determine what creates nexus in each state and what is subject to sales and use taxes in a particular state. Specific information will be coming soon to our website and you will be able to learn how each state handles this situation.

Now, let’s find out how the taxation of software is handled via the Internet. Nexus is key to a state’s jurisdiction to tax ESD transactions for purposes of sales and use taxation and income and income-based franchise taxation.

This articles discusses the tax base and sourcing rules, formulary apportionment, and compliance, including various proposals for taxing or not taxing ESD and other electronic commerce.

Your company may be able to achieve a competitive advantage by understanding the distinctions between "try before you buy" software, lease, a license, a sale of tangible or intangible property or the provision for services …with the sales tax consequences varying accordingly. For example, sales of $1 million of software together with services might generate a sales tax liability of $70,000 or more. Someone who can structure the transaction to avoid tax could offer a more affordable package; and the reduced tax may translate into additional sales.

As you know, sales tax is generally imposed on the retail sale or lease of tangible personal property and certain enumerated services (designed as "retail services").

Canned vs. Custom Software

Most states view software to be tangible personal property (subject to sales tax), which must be fungible (i.e., prepackaged, prewritten or "canned"), as opposed to customized software developed in a service transaction to meet the needs of a particular customer. For example, your company might need software developed that makes a presentation on your products. Nevertheless, otherwise taxable canned software may not be taxed if delivered electronically. The states vary widely in their interpretation of custom software, and very few tax both canned and custom software.

States that apply a narrow definition of custom software (generally not subject to sales tax) generally require that the software be developed specifically for one customer (like the above example). If the software is sold to another company, it looses its custom characterization and becomes taxable as tangible personal property! A state also may impose tax on charges for special modifications to canned software. A few states have a de minimis test whereby software is deemed custom if the prewritten portion is less than a specified percentage of the cost of the completed program. States that apply a broad definition of custom software generally provide that when modifications merely adapt prewritten software for compatibility with a customer’s hardware or software environment, the resulting package is nontaxable custom software.

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Tangible or Intangible Property;
License and Use Issues

ESD, of course, permits purely electronic delivery of digitized software products. The purchaser’s rights to use the digital program, however, may vary widely. For example, a purchaser (1) might make a single payment for the right to use the software in perpetuity for business or personal use, or (2) might obtain a license to reproduce any number of copies for further distribution. Some states view the purchase of a single copy of a program as a taxable transaction involving tangible personal property. Also, acquiring the right to make copies of software may be deemed the nontaxable purchase of an intangible. Most states view the sale of canned software, through a limited use license, as the sale of tangible personal property.

The terms of the license to use an intangible, and the degree of use, can dramatically affect the sales tax consequences of the transaction. In Illinois, for example, canned software is tangible personal property, and thus its sale is taxable. Under the state’s "Retailers’ Occupation Tax" regulations, however, a software license that meets all of the following conditions is not a taxable retail sale.

  • It is "evidenced by a written agreement signed by the licensor and the customer."
  • It "restricts the customer’s duplication and use of the software."
  • It "prohibits the customer from licensing, sublicensing or transferring the software to a third party (except to a related party)."
  • The "vendor will provide another copy at minimal or no charge if the customer loses or damages the software."
  • The "customer must destroy or return all copies of the software to the vendor at the end of the license period."

Mixed Sales Transactions

The sales tax treatment often is unclear when a transfer involves both tangible personal property and otherwise exempt services. Generally, such transaction requires a determination as to whether it is a sale of tangible personal property or merely a transfer of property incidental to the performance of a service that is the "true object" of the deal. Items that are inconsequential or incidental elements of a nontaxable service contract generally are subject to sales or use tax when purchased by the service provider. By contrast, service providers that opt to issue separate charges for such items generally must collect sales tax.

Maintenance and Support Services

The mixed transaction issue is particularly significant for companies that sell maintenance and support service contracts along with software products. Most software publishing companies offer some form of product maintenance and support. The tax treatment of ESD software support services generally depends on whether the software is taxable as (1) tangible personal property in the form of prewritten software, (2) a professional service in the form of custom software, or (3) other computer services.

To determine the optimal method of selling support services, the states’ tax treatment of the common components of support service agreements must be evaluated. The following issues should be considered in developing alternative methods of selling support services.

  • Which components of the support service agreements are subject to sales tax?
  • How does the tax treatment differ if the components are sold as optional or separate services?
  • How does the tax treatment differ if tangible personal property is (1) used as a medium of transfer, or (2) incidentally used or transferred in the course of providing the service?
  • How can the components be delivered so as to minimize the related sales and use tax consequences?
  • How should the unbundled components be priced?

Telephone and Electronic Support

Software maintenance agreements generally provide customers with rights to upgrades in software. Many times those agreements will include telephone and electronic support via the Internet. Sales of online service agreements, including software maintenance and support, may be wholly or partially exempt from tax. Generally, the tax treatment is based upon content. One of the first things to consider is whether the online service involves the transfer of software that is incidental to the service or is the primary object of the service.

For support services with respect to canned software, taxation often depends on sales terms and invoicing practices. In most states, sales of telephone and electronic support agreements that automatically are included with canned software are subject to tax. If the agreements are optional, then there may be partial exemption of the tax if the support services are separated on the customer’s invoice! Nevertheless, even with an optional agreement, telephone and electronic support services may be taxed if the customer does not have the option to buy the services separate from the software upgrades.

Software Delivered Electronically

Several states (e.g., California, Massachusetts, South Carolina and Virginia) provide exemptions for sales of software that is delivered electronically. In other words, in these states software that is delivered electronically is not subject to sales tax! It is best to check with each state to determine if electronic delivery alters that tax consequences.

Other rules and regulations may affect the characterization of a software transaction the action as a sale or license of tangible or intangible property. Treasury regulations, for example, and the Uniform Commercial Code as adopted with various modifications by the state, may be relevant to the character question.

Federal tax rules. Prop. Treas. Reg. 1. 861-18 concerns the character of certain transactions involving the transfer computer programs. Generally, for "the transfer of, or the provision of services or of Bell-tile with respect to, a computer program," the transaction will be characterized as one of following:

  1. "A transfer of a copy right in the computer program."
  2. "The transfer of a copy of a computer program (the use the copyrighted article)"
  3. "The provision of services of the development or modification of a computer program."
  4. "The provision of no-tile related to computer programming techniques".

The transfer of a copyright generally would involve what are more of the following:

  1. The right to reproduce a computer program for purposes of distribution to the public by sale, rental, lease, or loan.
  2. The right to prepare derivative programs based on a cooperation program.
  3. The right to make a public performance of the computer program.
  4. The right to publicly display a computer program.

Also under the proposal, a "copyrighted article" is a "copy of a computer program from which the work can be perceived, reproduced or otherwise communicated, either directly or with the aid of a machine or device." A leading industry group, the Software Publishers Association, has urged states, in applying P.L. 86-272, to characterize software sales as sales of copyrighted articles as defined under the proposed federal rules.

The proposal also provides that copyrighted transfer is a sale or exchange to the extent that substantially all the rights of copyrights are transferred. If less than substantially all the rights are transferred, the transaction is classified as the license generating royalty income. For a transfer of a copyrighted article, "[a] transaction does not constitute a sale or exchange because insufficient benefits and burdens of ownership of the copyrighted article have been transferred...will be classified as the lease generating rental income. Significantly, the proposal states that in applying the rules, the means of the transfer-electronic or otherwise-are not to be taken into account.

Sources for sales tax purposes. For tangible personal property, most states impose sales tax on the transfer title or possession or both by the seller to the purchaser. Generally, sales tax is imposed to pay a place of delivery, determine without regard to shipping terms. The taxes usually apply even when the purchaser immediately transports the goods outside the taxing state.

Some jurisdictions deem delivered to occur at the seller’s location if the goods are picked up there by a common carrier acting as the purchaser’s agent, but not if picked up by a common carrier acting as the seller’s agent. Thus, for example, a non-California purchaser and contracts with a common carrier to pick up goods at a vendor’s San Francisco facility will be subject to California sales tax. By contrast, delivery does not occur in the state if they could to pick up by common carrier acting on behalf of the vendor and delivered to the purchaser’s out of state location.

Drop-shipment transactions. Conflicting requirements may apply in determine which states can impose sale tax on goods purchased in one state and delivered by the seller to the purchaser’s designee in another state. A company may face a sales/use tax collection duty in two states if each deems delivery to occur in its own jurisdiction. This problem is largely administrative, however, since the risk of double taxation has been largely eliminated by the allowance of a credit against use tax for sales and use taxes paid to other states.

Sourcing and ESD. It is difficult to apply these land-based delivery principles to electronic commerce. For example, when software is electronically delivered to an online address, the software vendor must obtain the place of delivery or the customer’s residence by other means. In practice, the vendor must rely on information provided by the customer to determine the destination of the sale.

Income Tax: ESD and formulary apportionment. If you operate a company that does business in different states you must determine where the company’s corporate franchise and income tax liabilities will occur. There is a three-factor test to determine how much tax you owe in each state. This formula is based on; the company’s payroll, property and sales in each state. If you do business in three states, the total of your payroll, property and sales should add up to 100%. Then you would pay taxes in those states occurring to the specific percentage allocated in each state.

Because of ESD the sales factor and how that is handled in each state becomes interesting. As we mentioned earlier, software is treated as tangible personal property. This income is sourced to the state where the sale occurred. When software products are treated as services or intangibles, many states source sales of services and intangibles to the seller’s location! The problem is that a most states will source the sale of services and intangibles to the place where the income-producing activity occurs, based on the where the headquarters is located. While some states will do the opposite, they will source it to the location of the buyer. Double taxation can be a real issue since some states have adopted rules that increase the relative weight of the sales factor.

As we mentioned in earlier articles, it is important to understand Public Law 86-272. This says that in you are selling tangible personal property in other states only on a solicitation basis, you are not considered creating nexus in those states. The throwback rule provides that if the taxpayer is not taxable in the destination state, sales of intangible personal property are sourced to the state from which the goods are shipped.

For ESD, the initial question of whether the taxpayer has sold tangible personal property remains open, given the lack of clear guidance in the area. The states’ definitions of tangible personal property are not consistent and, thus, software vendors should carefully consider the various state rules in calculating apportionment.

The key in all this uncertainty is compliance. It is critical for small businesses especially to know the rules for keeping records for all your business done via ESD and to survive an audit.

Electronic recordkeeping. In March 1996, the Federation of Tax Administrators (FTA) released a proposed model recordkeeping and retention regulations (the "model regulation") that was developed by a coalition of state and industry representatives. The proposal is being adopted by a growing number of states. These rules seek to ensure that taxpayers maintain all records necessary to determine the correct tax liability under state statue. Here is an example:

    • The taxpayer may create files solely for the use of the state taxing authority but should document the process that created the separate file to show the relationship between that file and the original records.
    • "Machine-sensible records" (i.e., a collection of related information in an electronic format) must contain sufficient transaction-level information so that the underlying details relating to individual transactions may be identified and made available to the taxing authorities on request.

There are a couple of different software programs recommended to track your state tax planning. One is by Vertex, Inc. It has two software packages for sales and use tax compliance.

Recently, the Internet Tax Freedom Act was passed. It imposes a three-year moratorium on various types of state and local taxes, licenses, and fees on the Internet or interactive computer services. Nevertheless, the law grandfathers state and local taxes "generally imposed and actually enforced prior to October 1, 1998. Existing state and local taxes that are applied equally and fairly to both electronic and nonelectronic commerce are excluded from the moratorium.

The National Tax Association’s Communications and Electronic Commerce Tax Project (the "NTA tax protect") is considering several alternatives to the current tax regimes. The NTA tax project recently reached a milestone with its approval of a one-rate-per-state sales tax formula for all commerce. This agreement is but a small step toward overall consensus.

There are alternative suggestions that require federal legislation. One suggestion concerned nexus over out-of-state vendors based on the purchaser’s billing address. An alternative to the traditional nexus standard, this proposal sought to implement a taxing regime in which an out-of-state vendor of electronically transmitted information and services would have nexus in the state corresponding to the purchaser’s billing address. The vendor thus would have to make a reasonable and good faith effort to determine that address.

Absent the purchaser’s billing address, default rules would apply to assignee the sales and use tax base to certain states. Two rules were suggested-the "throwback rule" and the "throwaround rule"-under which the vendor would be presumed to have met any tax collection responsibility.

  • Throwback. The throwback rule would require the vendor to collect from the purchaser sales or use tax that may be imposed by the state in which the vendor has its principle place of business.
  • Throwaround. The throwaround rule would require a vendor to collect sales or use tax based on the average rate for sales taxes collected by the vendor on all sales of electronically transmitted information or services during the preceding calendar year. The vendor then would remit the tax to each state in the same proportion that the prior year’s taxes were paid to the state.

Alternative under traditional nexus standards. Taking traditional nexus standards into consideration, another alternative involved the situs of a transaction. Two categories would be established:

  1. Purchases either for personal consumption or by a business not known to be registered in the particular state.
  2. Purchases by a business known to be registered in the state.

Different tax reporting rules would be established for each category. A retailer would be relieved from collecting and remitting tax for sales involving registered businesses.

The NTA tax project also discussed the use of a congressionally implemented "state tax information clearinghouse." The clearinghouse would enhance enforcement of existing use tax laws by requiring central reporting of interstate, Internet sales of taxable property or services by vendors that do not maintain a physical business presence in the jurisdiction into which the sales are made. This procedure would apply only to transactions with respect to which no sales or use tax was collected or paid.

There is another group called the Software Industry Coalition. They believe that the collection responsibilities for Internet Transactions should be placed on the taxing jurisdictions. Their proposal notes that for digital products that are picked up electronically by the buyer from the seller’s website, no buyer zip code is required. In that situation, it remains to be seen whether the buyer’s state can impose a use tax collection obligation on the buyer, or whether the seller’s state will even consider the digital products to have been exported from the state.

Yet another group, Wade Anderson (Tax Policy Director in the Office of the Texas Comptroller of Public Accounts) has proposed a nationally assessed state sales tax on interstate electronic commerce that offers a unique approach focused on international aspects of sales and use taxation. Implementation of portions of the proposal would require federal legislation. The most unsettling aspect of this proposal is the fact that an out-of-state sellers without physical presence in the taxing state provide customer information to the state, or to a federal agency, to enable the state to collect use tax directly from its residents. This brings up some sensitive privacy issues.

By another proposal, there would be a single national tax rate for sales/use tax collections by Internet seller’s.

In conclusion, there are many different groups trying to adopt a new proposal to solve this complex Internet taxation issue. Also, the success or failure of the Internet Tax Freedom Act will also play a role in the future of the Internet.

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